Tiny Tax Cut Sparks Hope in Greece

In the aftermath of the turbulent year 2012, when austerity knocked the last breath of wind out of the European economy, there are some scattered attempts here and there to get the wheels turning again. Notably, those attempts are not coming from Brussels where political arrogance and an unrelenting belief in austerity still prevail. Instead, it is the national governments of the disaster-stricken economies that are launching one last brave rescue effort. It is far too early to tell whether or not these efforts will have any positive effect at all, but at least they should be recognized.

In Greece the incumbent prime minister has finally been able to convince the country’s creditor troika – EU, ECB and IMF – to accept a cut in the country’s confiscatory value added tax. Yes: international organizations, not the elected representatives of the people, have the final say on legislation. If the Greek people want lower taxes, they won’t get it; by contrast, as they have clearly demonstrated over the past year or two, the troika can override the will of the Greek people whenever it wants to. The result is nothing short of disastrous for the Greek economy.

With this in mind it is a blessing that the troika has now accepted a cut in the value added tax. Anna Visvizi, associate professor at the American College of Greece, writes in Euractiv:

On 1 August a long-awaited VAT reduction (from 23% to 13%) for hotels and restaurants was introduced raising hopes for the revival of this sector in the peak of the holiday season. At the same time, the Troika of Greece’s creditors remain sceptical about this measure arguing that the VAT reduction constitutes a risk to the fiscal consolidation programme.

This opening of Visvizi’s article clearly illustrates a point that I have been making for well over a year: austerity is not aimed at reviving the economy, but at making the welfare state fit within the narrower framework of a smaller economy. The purpose of a tax cut is to give consumers a chance to spend more money and therefore stimulate economic activity. By contrast, the purpose of a “fiscal consolidation” program is to achieve a static balance in the government budget.

Put differently, the purpose of a budget-balancing policy is not to revive the economy. The purpose of a tax cut, on the other hand, is to achieve an improvement in government finances as a positive spin-off of a return to economic growth. Politicians who have set their minds on the former strategy will disregard any evidence to the success of the latter strategy, which is important to keep in mind as we continue to listen to Anna Visvizi and her somewhat frustrated under-tone. In her Euractiv piece she attacks the fiscal-consolidation argument as representing…

a set of wrong assumptions underlying the way the crisis in Greece has been addressed since 2010; a malicious false logic as a result of which the Greek economy was ruined. At the core of this logic lies the assumption that by increasing taxation, the economy will be fixed. This is obviously an awfully wrong assumption!

Definitely. But it is important to keep in mind that tax hikes become an even more serious problem for a country when they are combined with across-the-board, panic-driven spending cuts. As much as there is a dire, long-term need to cut government spending in Greece, the layoffs of another 25,000 government employees in July this year will only add to the unemployment ranks. So long as high (and, as part of austerity, higher) taxes weigh down on the private sector, any layoffs of government workers will in large part be self-defeating.

Back to the Euractiv article where Anna Visvizi explains that the fiscal consolidation dictates have effectively allowed the troika to hold…

the current government hostage to politically driven commitments of previous governments, effectively blocking efforts at restoring growth in Greece. Prime Minister Antonis Samaras had to make several personal pleas to the Troika for them to allow him and his government to proceed with the VAT reduction. After a nearly year of Samaras’ efforts, the Troika finally agreed to decrease the VAT level but only for a limited period.

So it took the Greek prime minister a year to get permission for one single, isolated little measure that might at best register as a welcome blip on the macroeconomic radar. Don’t get me wrong – every tax cut counts. It is just a bit worrying that it took so long to get approval for it. Let’s hope that prime minister Samaras did not promise that Greece will be bathing in gold and growth because of this tax cut. The fact that he had to spend a year to get permission for it indicates that he might have had to promise a lot more than the tax cut can deliver.

Visvizi concludes:

This shows how surreal the situation in Greece is. The government wants to move towards reforms, yet the Troika – insisting on numbers rather than on reforms – blocks the government. As a result, four years into the crisis, the public sector in Greece remains untouched and the private economy is ever more squeezed by new regulation and immense taxation.

Well said. The risk with an over-promised tax cut is that when it fails to generate an immediate increase in tax revenue the troika will shut it down and say “see I told you so”. The problem, of course, is not that Greece does not need tax cuts – on the contrary, the country is in dire need of massive reductions on everything from income to consumer spending to property. No, the problem is that the troika does not consider the dynamic effects of fiscal policy in its policy dictates. Because of their entirely static approach to economic issues they are firmly convinced that there is no correlation whatsoever between their own austerity policies and the economic wasteland formerly known as the Greek economy.

A necessary (but not sufficient) condition for solving Greece’s problems is to take the country out of the euro zone, then eventually out of the EU. This is the beginning of a structural solution – and a very long economic journey back to prosperity. It is the only option for Greece, and for other troubled EU member states.

Such as Spain, another country in very dire straits. According to Der Spiegel the focus of the Spanish government is somewhat different than that of Greece:

The reorganization of Spain’s financial sector is seen as the most important part of the reforms introduced by conservative Prime Minister Mariano Rajoy to overcome his country’s economic and debt crises. But whether the plan will succeed remains uncertain, as real estate prices continue to slide amid continued concerns over the country’s financial institutions.

Greece “only” suffered a welfare-state crisis, brought upon it by structurally excessive government spending and structurally oppressive taxation. Spain, on the other hand, suffered a real-estate crisis on top of the welfare state crisis; the only reason why Spain is not in even worse shape than Greece is that its government was a Johnny-come-lately in terms of austerity. The destructive policies dictated by the troika (“eat this or get no money from us”) have not had as much time to poison the Spanish economy as they have had in Greece.

However, as Der Spiegel reports, Spain has its own mixture of problems:

There are also growing doubts about Rajoy’s abilities as a crisis manager. A corruption scandal surrounding Luis Bárcenas, the former treasurer of the governing People’s Party party, is a reminder to Spaniards of how a group of political and economic elites has taken the country to the brink of ruin. Bárcenas has admitted to maintaining a network of illicit accounts filled with money from various individuals, including developers, who made substantial donations to the party and its officials in return for lucrative contracts. It was this climate that allowed real estate prices to become more and more inflated.

There is a big lesson in this, obviously: government should not have the power to influence the real estate market. The collapse of the U.S. real estate market in 2008-2009 was brought about entirely by government-driven lending to people with questionable or outright bad credit. The federal government manipulated or completely destroyed the market mechanisms that would otherwise have ended irresponsible lending.

To make matters even worse, especially for the future, the U.S. government and European governments have bailed out troubled banks and rescued them from paying the ultimate price for irresponsible lending. This gives banks reasons to believe in future bailouts when they lend irresponsibly.

That said, we should also note that if government is causing irresponsible lending, government also has a moral obligation to help the banks. If we want neither to happen we need to elect more responsible legislators and presidents with a commitment to genuinely free markets.

That was a side bar, though an important one. Back to the Spiegel story:

[Crisis] management is not getting any easier for Rajoy. Only about 30 percent of the electorate still supports his government’s policies. Although there have been some successes, a number of reforms have been ill-conceived and only exacerbated societal divisions. Unemployment stands at 27 percent, and 2 million Spaniards get their meals from soup kitchens operated by social welfare organizations. “Spain has three core problems,” says Clemens Fuest, head of the Center for European Economic Research (ZEW) in the western German city of Mannheim, “the extremely overinflated construction and real estate sector, the ailing banks and rapidly growing government debt.”

Not an earth-shattering observation, but an OK summary. What Mr. Fuest forgets, though, is that the crisis would have been entirely manageable if the banks had not lost the low-risk anchor in their portfolios when Spanish treasury bonds fell through the credit-rating floor. From 2008 to 2012 the Spanish government sold 300 billion euros worth of treasury bonds to financial institutions, increasing their share of total government debt from 48 to 57 percent.

In 2012 financial institutions owned more than half-a-trillion euros worth of Spanish government debt. That is about twice as much as their estimated losses on bad real-estate loans.

The problems, though, are far from over. Der Spiegel again:

Two years of recession have wreaked havoc on Spanish companies, and the number of loan defaults is steadily rising. “If the country remains in recession for another year, more banks will be in trouble,” says Federico Steinberg, an economist at the Real Instituto Elcano (RIE), in Madrid. Although the banks have been stabilized for the moment, Steinberg says, they are providing the economy with too little credit. And although they can borrow unlimited amounts of money at extremely low interest rates from the European Central Bank (ECB), “the aid from the ECB doesn’t reach companies and households,” says Paloma López. “It only helps the banks.” López is part of the leadership of the CCOO trade union.

To whom would they lend? It does not matter how cheaply they can borrow the money if the person they lend it to won’t pay them back. In an economy with 27 percent unemployment there are not that many households to lend to for the purposes of mortgage or car loans. In an economy that has averaged 0.6 percent growth in the past five years, including forecasts for 2013, not that many businesses can promise the banks strong revenue in the future.

Spain should join Greece in a refocus on tax cuts and other measures to ease the pressure on the private sector. But it must be a sustained and comprehensive strategy; a temporary cut in one tax is not going to be nearly enough to turn around any economy in Europe.